What is financial leverage and how does it work

Elizabeth Smith

Just like Archimedes’ lever, businesses and investors can also “multiply the strength” of their capital with financial leverage. It is, however, a tool to be handled with caution. Here’s why.

“Give me a lever and I will lift the world.” Archimedes’ famous phrase indicated the potential of a simple tool that can multiply the force applied to it. Although applied in an entirely different sphere, the concept of leverage is not that far removed from Archimedes’.

What is financial leverage

Financial leverage is a tool (but at the same time an indicator) that allows one to invest an amount in the market that is greater than one’s capital.

Basically, through borrowing, an investor aims to have a high profit while having a low starting capital.

As always, however, potentially larger returns are matched by larger risks of loss. Leverage should therefore be handled with care.

Opportunities and risks: an example of financial leverage

Suppose-simplifying-that a trader has equity of 1,000 euros and has identified a stock with potential to grow 10 percent in one month. If he got his prediction right, he would cash out 1,100 euros after 30 days. But he could also incur a 10% loss, losing 100 euros and being left with 900 euros.

If, turning to a broker to obtain new liquidity, he used a leverage of 10 to 1 (investing a total of 10,000 euros) in the event of a positive outcome he would cash in 1,000 euros. Against an equity of 1,000 euros, then, the profit would be 100 percent, from which the interest to be paid to the broker would have to be subtracted. This small example is enough to understand the potential of leverage.

Beware, however, because this multiplier effect can also be reflected in losses. In the case where the stock had given up 10 percent, the losses would have been 1,000 euros. That is, they would have eroded the entire equity, not counting the interest owed to the lender.

The potential systemic effects

A certain level of leverage is physiological and allows investments to be accelerated. It is always a matter of measurement. In fact, the multiplier effect must be framed beyond the individual transaction, at the systemic level.

In fact, private traders can go as high as 20-to-1 leverage in the stock market and 30-to-1 leverage in the currency market.

If the entire system uses very high leverage, with abundant cross-borrowing, the fall of a single piece can trigger that of other players, infecting the market as a whole.

Leverage and businesses

Businesses also need to invest. And, to grow, equity may not be enough. Here then, translating the concept from financial markets to balance sheets, leverage becomes-as well as a tool-an indicator of the ratio of debt to equity.

It thus expresses the degree of dependence on third-party lenders. But not only that: it also affects the financial burdens that the company will have to bear. If leverage is high, the company is in fact perceived as more risky by potential creditors, who will consequently demand a higher remuneration for lending.

Or, in the most extreme cases, they may deny it. Typically, a debt-to-equity ratio of less than 3 (e.g., 300,000 euros on 100,000 euros of direct investment) is evaluated positively. Risks increase when the ratio exceeds 5 to 1.

Read also: ETFs and mutual funds: their differences, advantages and disadvantages

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